One vital decision you’ll have to make when applying for a mortgage is if you want to go for an open vs. closed mortgage. When it comes to purchasing a home, every Canadian’s situation is different. So, mortgages are designed with different types of borrowers in mind. That is why they come in various forms, i.e., open vs closed mortgage, fixed vs variable, 3-year, 5-year, 10-year term.
The one you choose can either result in considerable savings or more costs for you. The most important thing is to make the right choice. While an open mortgage gives you the flexibility to pay off your mortgage at any time, a closed mortgage more strict and can attract penalties if you pay before your mortgage term ends. So you need to consider your situation to decide between an open vs closed mortgage. Let’s get into it.
Open vs Closed Mortgage in Canada- An Overview
An open mortgage comes with flexibility such that you can pay off your mortgage fully or in part at any time with no penalty. On the other hand, a closed mortgage has stricter rules. If you pay it off early, they will penalize you.
Although the pre payment penalty is a red flag, a closed mortgage has lower interest rates than an open mortgage.
Closed mortgages are pretty common in Canada because of the lower interest rates. Also, most people don’t need the additional flexibility that comes with an open mortgage. If you are expecting extra cash that can significantly increase your income and pay off your mortgage, then an open mortgage would be a better option.
Before we go into a detailed comparison of open vs closed mortgage, let’s define two important terms below.
Open vs Closed Mortgage: What is Amortization and Term Period?
The amortization period is the total number of years it would take the homeowner to pay off the entire mortgage amount. Usually, it is around 25 or 30 years, but you can reduce the tome by following these steps:
- Raising your payment amount- Even if it’s by a small amount, increasing the amount you pay can make a huge difference.
- Increasing the frequency of your payment- The more regular your payments are, the lower the interest charged against your principal amount.
- Leverage your prepayment options to make a lump sum payment.
The mortgage term is a shorter period of time when you are committed to a certain lender and interest rate. For instance, your bank might provide mortgages with 1-year, 2-year, 3-year, or 4-year terms.
When the term elapses, you can pay the balance you owe, renegotiate your rates, change your lender, or renew your term. You will possibly renew your term on several occasions through your mortgage’s lifespan till you pay the full amount.
There are two types of mortgage terms— closed term and open term.
To summarize, the amortization period consists of several terms.
As mentioned earlier, this type of mortgage can be refinanced, re-negotiated, or paid in full at any time. In other words, it comes with no prepayment charge or restrictions. However, an open mortgage comes with a term— the mortgage holder does not have to hold it till it matures.
Open mortgages also usually have higher interest rates than closed mortgages because of their payment flexibility. This is why they are not as commonly used as closed mortgages. While you’ll get closed mortgages across all the popular terms, open mortgages are mostly just available for short terms, usually five years or lower.
An open mortgage might be right for you if you plan to sell your home within a year or pay off your mortgage shortly. For instance, suppose you get a huge work bonus, receive a monetary inheritance, or another type of financial boost.
Using that proceeds to pay off your mortgage early can save you the money you’d have paid on interest in the long run.
Open vs closed mortgages come with their pros and cons. For open mortgage, they are:
Pros of Open Mortgage
- You have the freedom and flexibility to pay any amount you want.
- You don’t need to worry about penalties if you decide to increase your regular payments or pay off your loan earlier.
- You can make a lump sum payment on your mortgage at any time with no penalty or fine.
- Open mortgages have shorter terms so if some financial uncertainties arise, you can refinance or reach maturity faster if you want.
Cons of Open Mortage
- Lenders can propose higher mortgage rates due to an open mortgage’s flexibility.
- The higher interest rates end up increasing the overall cost of borrowing.
A closed mortgage is a type of mortgage that you cannot fully pay off, re-negotiate, or refinance before the end of its term. If you do, you’ll have to pay the penalty. They generally have attractive interest rates compared to open mortgages, but borrowers are offered limited flexibility.
Purchasing a closed mortgage means agreeing and committing to its terms and conditions throughout the term. A closed mortgage is usually a better choice if you don’t plan to pay off your mortgage in the short term, and you want a monthly fixed rate for your mortgage payments. Doing this can help you and your family budget your mortgage payments and other expenses.
You can get a level of payment flexibility on closed mortgages. Depending on your lender, you can increase your monthly payments by a specific percentage and pre-pay an extra amount of money annually as your mortgage’s percentage.
However, if you decide to pay off the mortgage before the term’s end or exceed the allowed prepayment mortgage limit, you’ll be hit with a pre-payment penalty. You can estimate various prepayment penalties for several scenarios using a mortgage penalty calculator.
As said earlier, open vs closed mortgage come with their up and downsides. Let’s look at closed mortgages’ own.
Pros of Closed Mortgage
- Mortgage interest rates are lower.
- There are a few pre-payment options that will permit you to pay your mortgage faster.
- The lower interest rates make the overall cost of borrowing lesser.
Cons of Closed Mortgage
- Lump-sum payments, refinancing, and renegotiating your mortgage term attract significant penalties.
- The terms are longer, usually between 6 months to 10 years.
What is a Convertible Closed Mortgage?
A convertible closed mortgage offers you the same perks as a closed mortgage. However, it can be converted and extended to a longer, closed term at any time without attracting prepayment charges.
Closed Mortgages with Fixed vs Variable Rates
Apart from deciding between open vs closed mortgage, a variable or fixed interest rate is another decision you may have to make. Closed mortgages with variable interest rates usually have lesser prepayment penalties compared to closed mortgages with fixed rates.
Your best option might be to go with a closed mortgage with a variable rate. You can get some of the lowest mortgage rates possible, reducing the potential size of your prepayment penalty, if you need to refinance or pay off your mortgage later on.
The down side of opting for the variable rate is yow won’t be protected from prime mortgage rates. Therefore, your regular payments throughout your mortgage term can increase.
Open vs Closed Mortgage: How to Choose the Right One for You
Most Canadian homeowners prefer a closed mortgage because of the notably lower rates, which can help save a lot of money throughout the mortgage term.
However, the additional flexibility attached to an open mortgage can come in handy if you are expecting additional money soon that you’d love to use to settle your mortgage. Other situations that may warrant an open mortgage are:
- If you have an inheritance coming: If a cash inheritance is on the way, an open mortgage is flexible enough to allow you to use that fund to pay off a lump sum of your mortgage. It’ll attract little or no penalties.
- You plan to sell your home soon: If you plan to sell your home soon and pay off your mortgage with the money from the sale, then an open mortgage might be your best bet. This is because paying off a closed mortgage can attract considerable prepayment penalties.
- Your household income is about to rise: Suppose you are expecting your household income to increase soon, for example, an upcoming promotion, you can increase your regular mortgage payments penalty-free with an open mortgage.
Overall, before you decide on open vs closed mortgage, consider:
- If you’ll be able to pay every month.
- The possibility of a situation where you can pay off your mortgage early coming up.
- Your monthly expenses as you can’t afford to go into debt with a mortgage hanging over your head.
- If you plan to sell your home before the mortgage end date
Open vs Closed Mortgage:
Some Tips for First-Time Home Buyers in Canada
- Be familiar with programs that provide financial encouragements to first-time homebuyers.
- Pay special attention to the First-Time Home Buyers’ Tax Credit, the Land Transfer Tax Rebate, and the RRSP Home Buyers’ Plan.
- Learn and be clear on the difference between open vs closed mortgages.
- Shop around and and compare the most competitive mortgage rates.
FAQs- Open vs Closed Mortgage
What is the difference between closed and open variable mortgage?
Open vs closed mortgage
An open mortgage comes with flexible options that allows you to increase your mortgage repayments, whether by raising your regular payments or by paying a lump sum. On the other hand, a closed mortgage will hit you with penalties if you pay off all or part of your mortgage before time.
Can you pay off a closed mortgage early?
After you opt for a closed mortgage, you’ll pay three months of interest as a penalty if you wish to get out early. Your lender can then sign a new borrower at a higher rate. But if interest rates drop, you’ll be paying more than three months’ interest as a fixed-rate penalty.
How can I get out of my mortgage without penalty?
If you intend to get out of your mortgage later and avoid penalty fees, you should go for an open mortgage or a shorter term.
Unlike a closed mortgage, an open mortgage allows you to settle the entire mortgage balance anytime throughout the term without attracting a penalty.
What is the shortest mortgage term?
An 8-Year Mortgage is one of the shortest mortgage loan terms you can get. It’s not as widely used as the popular 15- and 30-year loan terms, but it allows you to pay down your loan aggressively pay down your home loan, and own your home exclusively in under ten years.
Is it worth breaking my mortgage?
Before, breaking your mortgage when you get a new rate at least two percent lower than your current rate was seen as worth it. However, that’s no longer the case. You can see big savings depending on your penalty for breaking your mortgage.
Can you get a 1 year fixed rate mortgage?
Yes, a one-year fixed-term mortgage could give you the following perks:
They are cheaper because the lender undergoes less risk.
The repayment charges are lesser than those for longer-term fixed rate mortgages.
Is it better to get a 15 year mortgage or pay extra on a 30 year mortgage?
In this scenario, a 30-year mortgage has a longer term, so it’ll come with lower monthly payments and higher interest rates than the 15 year mortgage. However, because the 15-year mortgage’s interest rate is lower, and you want to pay off the principal faster, you’ll have to pay a lot lower in interest over your loan’s lifespan.
Bottom line: Open vs Closed Mortgage
Now that you know the difference between open vs closed mortgage, the question is how to find the best rates? When you are shopping around for a mortgage, you make several decisions that affect you in the long run. Your decision can either save you thousands of dollars or earn you prepayment penalties. So, it’s vital to make the right one.
To get the best mortgage rate, you should do your research and understand your finances. There are several options to choose from, but buying a house is an essential chapter of your life and you need to make an informed decision.